|
Closed-end funds represent one of the best investment opportunities in the market today. There is a place in every balanced portfolio for a diversified equity closed-end fund like Adams Express and a specialized sector closed-end fund like Petroleum & Resources. Every prudent investor should give serious consideration to adding them to his or her investment portfolio. Here is some information that may assist in your consideration.
A closed-end fund (“CEF”) is a professionally managed portfolio of securities that operates like a typical corporation. Just like an open-end fund (which is more commonly known as a mutual fund), the CEF’s assets are the diversified portfolio of stocks and other securities that it owns and manages.
When a CEF is founded, it has an initial public offering and a fixed number of shares are issued, just like any other public company. Those shares then trade on a stock exchange and new investors in the fund obtain their shares by buying them from existing investors who are looking to sell, also just like any other public company. A mutual fund, by contrast, issues an unlimited number of shares and issues new shares to each new investor. Investors who desire to sell their shares actually have their shares “redeemed” by the mutual fund. There is virtually no difference in the liquidity of a CEF and that of a mutual fund. Shares of Adams Express and Petroleum & Resources trade on the New York Stock Exchange.
The price of a share of the CEF is set by the market and may or may not correspond to the net asset value of the fund’s portfolio (“NAV”). This can result in the CEF’s stock price trading at a discount from or premium to the NAV.
top
A) No Constant Inflow and Outflow of Money
The most obvious difference is that a CEF does not have a constant inflow or outflow of cash. Mutual funds take in new money from, and issue new shares to, each new investor. In most instances, when a mutual fund investor decides to sell his or her shares, they are redeemed by the mutual fund at the fund’s NAV. Accordingly, the mutual fund must either keep enough money on hand (and therefore not invest it in securities) to meet redemptions or sell existing positions to raise the money to pay redemptions. This can force the mutual fund manager to sell off portfolio holdings based on demand from shareholders who want to get out of the fund, which can often happen at the absolute worst time, such as a sharp market downturn. The constant inflows of money can also make mutual funds victims of their own success. The inflows must be invested by the portfolio manager at times when good investment opportunities may not exist, which can create a drag on the fund’s performance.
The shares of a CEF, on the other hand, are traded in the public market and the buying and selling of the CEF’s shares does not result in any inflow or outflow of money in the CEF. A CEF does not have to make redemptions (and it can remain fully invested) or figure out how to put inflows of money to work. The portfolio manager is thus able to control the timing of when portfolio securities are bought or sold and can choose the time horizon for his or her investments that best fits the fund’s philosophy. This can be especially important in market downturns. This stable environment permits the CEF portfolio manager to concentrate on achieving long-term goals rather than focusing on short-term marketing considerations.
B) The Closed-end Fund’s Focus is on Current Shareholders
With a fixed amount of capital, a CEF is not generally involved in attracting additional funds and the CEF shareholder is not required to pay for the costs of attracting new investors. The mutual fund portfolio manager, however, has an incentive to attract new shareholders because the amount of fees earned by the managment company in no small part depends on adding new money to the fund. In order to market the mutual fund to new shareholders, current mutual fund shareholders are often charged a front-end or back-end load and marketing fees, commonly known as 12b-1 fees, which reduce the current shareholders’ returns. In contrast, CEF investors are not burdened with these fees. Thus, the CEF portfolio manager is able to focus on returns for current shareholders, not attracting new ones.
The drive for more and more new shareholders may also cause the mutual fund portfolio manager to fall into the “quarterly performance derby” trap in which he or she is forced to be on the lookout for the latest, hottest security to keep his or her performance up. This may lead to increased turnover in the stocks held in the portfolio.With the changes in the capital gains rate favoring portfolio securities held for twelve months or more, this turnover in the portfolio may result in substantial tax consequences for the mutual fund investor.
C) The Opportunity to Buy at a Discount
The market sets the price of a share of a CEF, and the shares can trade at a discount or premium to the fund’s NAV. By buying shares at a discount, an investor can earn added returns. One way this happens is because income is earned and gains are realized on the CEF’s total assets. So an investor receives the return on a dollar of assets even though he or she paid less than a dollar for those assets, due to the discount. In addition, the discount may narrow over time (of course, it also could expand, depending on the market), which can also result in a higher yield on the initial investment. The discount also provides a shock absorber when the broader markets drop. Because an investor was able to pay less than NAV for the shares, the investor who has bought the stock at a discount has a cushion against a drop in the value of the portfolio resulting from a market downturn. Thus, more than one adviser has observed that one way of looking at the discount is as a bonus that may produce added returns over time.
D) The Benefits of Trading on an Exchange
Finally, because a CEF trades on an exchange, an investor who sells gets the current price for the shares, knows immediately what that price is and the amount that was realized on the sale, and does not have to wait until the end of the day to find out what the selling price was*. A CEF must also abide by the rules and regulations of the exchange on which its shares trade, thus adding another layer of protection for shareholders.
top
* Note that these considerations may not apply to CEF investors who sell their shares through a fund’s dividend reinvestment plan. Such plans frequently provide that sales will only be made on a weekly or monthly basis, as demand and market conditions justify. Thus, an investor in a dividend reinvestment plan may not be able to set the exact date for when the shares are sold. In addition, the sales price received will most often be an average price that is not determined until after the sales are completed. You should consult the terms of your dividend reinvestment plan to see how they apply to your investment.
|
